Regulatory Limbo for Hedge Funds

Experts say hedge fund advisors who registered with the Securities and Exchange Commission in response to the now-shelved hedge fund rule aren't likely to see examiners on their doorstep anytime soon.

Darren Sherman, a former senior SEC official and now chief executive of Regulatory Advisory Services, said the U.S. Appeals Court's decision striking down the rule in response to a suit brought by Phillip Goldstein threw "a wrench in the wheels of the examination program." He says that the SEC staff has suspended examinations of all hedge fund advisors that wouldn't have been required to become registered investment advisors before the hedge fund rule was enacted.

A likely course of action, according to Sherman, is implementation of a lighter regulatory regime, without making actual changes to the Investment Advisers Act of 1940. That would mean that the SEC would require all managers regardless of registration status to provide some basic information to the agency, which Sherman said could include things such as a firm's name, assets under management, investment strategies utilized, number of investment vehicles and the criminal history of the firm's principals.

In a recent speech, outgoing SEC Commissioner Cynthia A. Glassman, reiterated her earlier suggestion to her fellow commissioners; she argued that using its power to issue a notice and filing rerequirement would give the SEC a census of existing hedge funds and useful information.

Instead, under the 2006 rule, "What we ended up with was a limited census (the rule as adopted exempted advisors of hedge funds that had had two-year lockups or that had fewer than 15 U.S. investors) and also information of limited usefulness on the investment adviser registration form," Glassman said.

The SEC has a few weeks to file an appeal of the ruling, but even Comm-issioner Paul Atkins, who voted against the hedge fund rule, has said that such a move is unlikely.

For now, the SEC's probably staying away from newly registered hedge funds, said Daniel Y. Smith, senior principal consultant in the Chicago office of the regulatory consulting firm Adviser Compliance Associates LLC.

One of ACA's consultants observed at a client examination the day the District of Columbia U.S. Court of Appeals' decision to vacate the SEC's hedge fund rule was handed down that "it was obvious that the examiners were unclear how to proceed," Smith said.

The examination team sought guidance from their home office, and that office likely queried Washington on how to handle the situation. In the end, the examiners scaled back the number of requests they made for information and canceled the interview with the firm's chief portfolio manager.

Smith, a former SEC examiner himself, said he's seen onsite visits last anywhere from three days to eight weeks, with months of follow-up. He stressed that there is no generally accepted time frame for an exam, but that in the case of the truncated client examination, it was likely that the hedge fund's intention to de-register following the court decision probably played a role in the examiners decision to call it a day. --Jeff Joseph & Susan L. Barreto

Jeff Joseph is managing director of Alternative Strategies at RydexInvestments and also serves on the advisory board of HedgeWorld (www.hedge world.com), a global provider of hedge fund information and investment products. Susan L. Barreto is a HedgeWorld Senior Financial Correspondent.

Everyone has some questions about hedge funds. Feel free to send yours to Jeff Joseph by e-mail at jjoseph@rydexfunds.com.

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